A Brief Primer on Business Development Companies (BDC) Part 1: What are BDCs and why should you invest in them?

Business development companies (BDCs) are companies that specialize in investing in private companies – similar to how private equity or venture capital investors operate.  BDCs make loans and often take ownership stakes in their client companies and supply managerial assistance.  When the client company makes money, the BDC makes money.  Investing in BDCs can be a great way to dip into the exciting venture capital world without having to become an accredited investor and pony up a ton of money. Just buy and sell shares of the BDC on a stock exchange, like you would any other stock.  Because BDCs usually pay out almost all (>90%) of their taxable earnings you can earn substantially higher dividend yields through BDCs than you could with traditional stocks.  But be warned, when the economy tanks, the BDC’s dividend gets the axe!

A Brief History of BDCs

In 1980, Congress created BDCs as a means to allow regular people (that’s you and me) to the ability to invest in private equity companies. In other words, Congress created the means of establishing public vehicles (the BDCs) for investing in private companies.  In the old days, these kinds of potentially lucrative private equity and venture capital investments were limited to wealthy clients and private firms.  With the advent of BDCs, anyone can buy shares of BDC on a stock exchange, just like any other security.  Oddly enough, BDCs didn’t really take off for 20 years or so.  Only about three companies existed in 2000.  Today there are over 30.

On a more somber note, the Great Recession (2008-2009) was particularly hard on BDCs.  But as the economy has improved, BDCs are once again prospering.

 

How do BDCs make money?

BDCs make money by helping other businesses grow and succeed.  BDCs make short-term unsecured loans. In return, the BDC often receives an ownership position in the business.  In addition to the loans, BDCs must offer significant managerial assistance to their client companies.  They are business DEVELOPMENT companies, after all.  As the client companies become more profitable, the loans are repaid back and the equity can be sold at a profit.  This is basically what private equity or venture capital firms do.

 

Characteristics of BDCs

BDCs are pass through entities, similar to real estate investment trusts (REIT).  BDCs do not pay corporate taxes on their earnings, but are required to distribute 90% of their taxable income to shareholders.  Most BDCs distribute 98% of their earnings in order to avoid all corporate taxes.

BDCs must invest at least 70% of their assets in privately held or thinly traded companies, and as mentioned above BDCs are required by law to provide managerial assistance to their client companies.

There are tight limits on how much debt BDCs can take on.  Their leverage cannot exceed 1:1.

BDCs are often very diversified.  No single investment can exceed 25% of their portfolio and it is not uncommon for a BDC to hold dozens of investments.  The reality of the venture capital world is that a lot of those client companies aren’t going to make it, so the more diversified a BDC is, the less sensitive it is to the failure of an individual client company.

Several BDCs are sponsored by heavyweight asset management companies.  For example, the BDC BlackRock Kelso is sponsored by BlackRock Inc, which routinely handles trillions (with a T) of dollars in assets.  These kinds of BDCs have access to a tremendous amount of capital, connections, and management experience.

 

Why invest in BDCs?

1. High yields - Because, by law, BDCs are not taxed at the corporate level and must pay out over 90% of their taxable income, high yields are common.  Yields around 10% are not uncommon.  Because BDCs are not taxed at the corporate level, the dividends will be taxed as ordinary dividends, rather than the lower rates used for qualified dividends.

2. Liquidity - BDCs are liquid investments that are traded on public exchanges.  You can buy and sell shares of a BDC whenever markets are open.

3. Diversification into private equity and venture capital - BDCs allow individual investors to diversify their portfolio in the high risk / high return world of private equity.  Without access to BDCs, an individual investor would have to reach the status of “accredited investor” and then be willing to hand over a sizable amount of their capital to just one client company.

4. Some BDCs have elements of dividend growth stocks - Only one BDCs has characteristics of good dividend growth stocks – regular increasing dividend payments for at least 5 years.  Pulled from the dividend challengers list.

• Pennant Park Investments (PNNT, 6 years of consistent increases)

While the 2008-2009 recession was particularly hard on BDCs, it is likely that as the economy improves, more BDCs will develop histories of regularly increasing dividend payments.

 

Conclusions

BDCs can be a valuable addition to your dividend portfolio, giving you exposure to the kinds of investments only available to venture capitalists and private equity firms. While BDCs tend to produce high yields, they can be very sensitive to economic conditions.  In other words, when the economy goes South, it’s likely to take your BDC dividend with it.  While I am bullish about BDCs, I prefer to limit my portfolio’s exposure to them.  I also check for the lowest dividend payment in their history and use that as a potential guide as to just how bad things could become in an economic downturn.

Disclosure: I currently hold one BDC – Prospect Capital (PSEC).

Readers:  What do you think of BDCs?  Do you currently invest in any?